How to save the euro zone

April 10, 2012

By Kathleen Brooks. The opinions expressed are her own.

There’s a 250,000 pound prize for the best idea on how to break up the euro zone, but how much would you pay to see the euro zone saved?

There is no denying that the euro zone is in a mess right now, but there are some steps that could help ease the crisis. Essentially the markets hate to be 1) misled and 2) confused. The European authorities have consistently sent mixed messages and reneged on their promises. For example, they said there would be no haircut on Greek debt then when it became obvious Greece had to re-negotiate its massive debt pile the authorities said Greece would be the exception. Now the markets believe there is a good chance that Portugal will have to follow suit.

Thus, the first step to saving the euro zone in its current form is to sort out communication. If debts need to be re-structured in Portugal and Ireland then the European authorities should call an emergency meeting and come up with a broad set of parameters and rules for cutting these weak peripheral states’ debts. These could include; 1) a certain debt to GDP ratio that once surpassed mean that debts have to be re-negotiated; 2) A set percentage of debts to be renegotiated and no more than that; 3) Finally, a timetable for repaying the outstanding debts that is realistic. The debt repayment plan would be based on realistic growth assumptions then penalties could be applied if the schedule is missed.

The Fiscal Pact may be a new stage in the euro zone project, but in its current form it is only going to promote bickering, one-upmanship and the eventual disintegration of the currency bloc. The Fiscal Pact contains some good ideas, but the plan for budget deficits to return to no more than 3 percent of GDP by 2013 is too ambitious.

The euro zone has always been made up of diverse economies, so rather than creating one rule for all the authorities, it  would be better to have scaled fiscal targets. For example, for Spain they would need to take account of weak growth and an enormous unemployment rate to come up with a more realistic fiscal consolidation timetable. The markets are punishing the Spanish bond markets today for missed fiscal targets tomorrow. The markets aren’t reacting to the absolute levels of Spanish debt, instead markets tend to react negatively to missed expectations. Thus, one way to calm markets is to lower expectations and make the bar easier for Spain to get over.

This brings me to another point. Re-adjustment in the euro zone needs to take place, but it can’t happen overnight. It is a multi-year, maybe even decade-long process. Due to this it needs a safety cushion during the intervening period. The cushion could be a beefed up financial firewall to ensure that Spain, Italy etc. have a source of funds to tap if the markets get a bit jittery in the coming weeks and months. The only country who can provide this is Germany. It has the money (and the credit rating) to help beef up funds to the magic 1 trillion euro mark that could placate the markets as Europe’s periphery navigate their way through a harsh austerity era.

The final point is politics. Politics is poisoning the euro zone and could be its undoing. Elections in Greece and France could be game changers for the bloc this year, and could make the sovereign debt crisis a whole lot worse. Likewise, Angela Merkel is all too aware that she can’t spend her taxpayers’ euro too freely on bailing out fiscally irresponsible peripheral states as she has her own election to fight in 2013. Italy’s technocratic (read unelected) Prime Minister took aim at Spain the other week to push Madrid to tighten its fiscal targets. This behaviour will only promote rivalry and bitter disputes at just the time when the euro zone needs to pull together. We really need to see Europe’s leaders, even those who face elections in the next 18 months, to put their own interests aside and work on saving the euro zone, otherwise they will go down in history as the ones who let the currency bloc crumble under their watch.

These are just a few ideas and nowhere near as in depth as the entries to the Wolfson Prize for Economics on how to break-up the currency bloc. But if a few common sense ideas were employed by Brussels then the euro zone project stands a chance of staying in its current form. Without change, it is on the road to disaster.

Image — A man walks next to policemen outside an Eurobank branch in Athens March 21, 2012. REUTERS/John Kolesidis


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